In Search of…Crowding Out

There are various definitions of crowding out. There’s crowding out in the financial markets, and crowding out of actual economic activity. In order for crowding out in the financial markets to translate into a reduction of the interest sensitive components of aggregate demand, one needs to see an impact on interest rates. So, what is happening to real (inflation adjusted) interest rates?

First, let’s take a look at the nominal interest rates, both the risk free and risky.


Figure 1: Ten year constant maturity yields (blue) and AAA corporate debt yields (red). Observation for February is 2/17. NBER defined recession dates shaded gray; assumes last recession ends 09M06. Source: FRED II, and NBER.

Second, we can adjust these nominal interest rates by expected inflation rates over a ten year horizon. Here we use the Survey of Professional Forecasters predictions, which apply to the second month of each quarter.


Figure 2: Ten year constant maturity yields (blue) and AAA corporate debt yields (red), adjusted by ten year expected inflation. Observation for February is 2/17. NBER defined recession dates shaded gray; assumes last recession ends 09M06. Source: FRED II, Survey of Professional Forecasters via Philadelphia Fed, and NBER.

Real interest rates appear to be relatively low, lower than in the previous recession. Since these estimates of the ex ante real interest rate rely upon survey based measures of inflationary expectations, one could criticize them as being mismeasured.


Figure 3: Ten year constant maturity yields adjusted by ten year ahead expected inflation (blue squares) and ten year constant maturity TIPS (red). Observation for February is 2/17. NBER defined recession dates shaded gray; assumes last recession ends 09M06. Source: FRED II, Survey of Professional Forecasters via Philadelphia Fed, and NBER.

However, the Treasury inflation protected securities (TIPS) yields suggest a similar pattern for real rates, excepting the period right after the Lehman bankruptcy, during which time TIPS and other yields behaved erratically).

So, what is one to make of these data? In a standard model of portfolio crowding out (see derivation here), budget deficits should induce higher interest rates, and hence lower investment. Of course, not all else is held constant. In particular, the Fed has aggresively purchased Treasurys and other longer term assets, including mortgage backed securities. This manifests itself in continuous shifts rightward in the LM curve.

Chapter 5 of the Economic Report of the President, 2010, notes:

…In the current situation, as discussed in Chapter 2, monetary
policymakers are constrained because nominal interest rates cannot be
lowered below zero, and so they are unlikely to raise interest rates quickly
in response to fiscal expansion. As a result, the fiscal expansion attributable
to the Recovery Act is likely to increase private investment as well as
private consumption and government purchases. …

A relevant question, is what happens when the Fed exits from quantitative easing (and relatedly, as slack in the economy declines). That being said, extreme upward pressure on interest rates, and reduction in investment expenditures, is not a foregone conclusion.

Crowding out has a strong hold on many people’s imagination. Some equate crowding out in the financial market with crowding out in the real side of the economy. Let me make a couple observations on why this simplistic equation need not hold.

First, the empirical magnitude of investment crowding out depends critically on the interest sensitivity of investment expenditures.

Second, if investment depends upon the change in GDP, as in a simple accelerator model (see a discussion of competing investment models here), then government spending that induces an increase in GDP can result in higher investment, despite an increase in interest rates.

Third, when one assumes three (or more) outside assets instead of two, then money and bonds are not necessarily substitutes. Benjamin Friedman laid out a model with money, bonds and equities/capital. Depending upon whether bonds are closer substitutes with capital or money, one can obtain crowding out or crowding in (see this powerpoint presentation).

I teach crowding out in the context of the IS-LM model. For those who want to work in the loanable funds framework, see DeLong, and Krugman.


20 thoughts on “In Search of…Crowding Out

  1. bryce

    “Of course, not all else is held constant. In particular, the Fed has aggresively purchased Treasurys and other longer term assets, including mortgage backed securities.” I’m glad you included this remark. I don’t mean to be harsh but, it expresses the otiosity of the rest of the post.

  2. David Pearson

    The Fed is purchasing roughly $1.75tr of term securities under its MBS, Treasury and Agency programs. While it is not a “foregone conclusion” that we will see extreme moves in term rates when the program expires, it is also not quite conclusive to look for crowding out in the interest rate data from the period of QE. So why present the graphs without that caveat?
    Further, is a comparison of current real term rates with peak rates even relevant? The 2yr/10yr yield curve steepness is near record levels. What does that tell us? Well, for one thing, it tells us that the Fed’s ZIRP and QE policies have been unsuccessful in bringing down long rates as much as one would have thought given the massive intervention. Which of course begs the question, what will these rates look like without that intervention? Until we know the answer, it is premature to make conclusions about the effect of fiscal deficits on “crowding out”. Again, why not state this up front, rather than as an aside?

  3. Cedric Regula

    Personally, I was so sure we didn’t have any kind of crowding out that I didn’t bother to go searching for any.
    Fed balance sheet doubles, interest rates are nothing, analysis of S&P 500 corps show capital spending dropped to nothing. They are selling a lot of corp bonds, but that’s because they can re-finance at lower interest rates. We have a pretty good handle on the consumer loan demand picture. The only ones that want a loan can’t pay it back, so we shouldn’t count them. The savings rate is way up for the rest. And, oh yes, just about every economist thinks we are in a liquidity trap.
    Going forward that could rapidly change into a different picture. I saw an estimate there will be about a $700B shortfall to fund Treasury’s appetite, from the usual sources like foreign investment from projected trade deficits, and the new domestic savings rate we have. I think it comes from the stock market, or better yet, commodities market, but one can never be sure about these things.

  4. Brian Quinn

    I’ve always been skeptical of most arguments regarding crowding out, but one thing that would be interesting to see is if credit spreads start to widen in absence of any further financial crises. If Aaa and Baa corporate spreads started to balloon out in otherwise stable capital markets in the presence of continuously large deficits, then I might be able to see the argument. This would seem to indicate that large budget deficits, while not necessarily pushing treasury rates substantially higher, are forcing companies at the margins to pay more to investors due to an overabundance of “safe” government paper.
    As of yet, I have not seen evidence of this. Spreads remain somewhat (though much less so than previously) elevated largely due to residual impacts of the financial crisis rather than fiscal actions.

  5. Brian

    It’s not just Fed buying of long term paper that’s also causing distortions: the Fed funds rate effectively being zero, hot money flying around, and outright fraud and distorted information.

    First, you would have to be out of your mind to trust anything rated AAA in this environment, especially in light of all that AAA garbage from MBS. The problem this creates is that how can you say that your data is sound?

    And then we have a little problem with the government stat hackers pumping up every “advance” data release–last quarter we went from a GDP of 3.5% to 2.7% to 2.2%. And now this ludicrous 5.7%?! To believe this, especially given the BEA’s poor predictions in the past, you would have to be incredibly asleep at the wheel.

    All this intervention, fraud, government management of perception, low interest rates, and so forth–when does it dawn on the academics that the data you’re plugging in is more than likely not reliable? How could you possibly gauge what a fair price for a 10yr US bond is? 10 years?! No one even knows what’s going to happen next week. How can anyone gauge what any asset should be priced at? What the market will give you? But that simply is a tautological statement. In late 2008 I bought palladium for around $190/oz and then recently sold it for $430/oz–was this an accurate price for this metal? I don’t know, but these things do matter because if palladium is vastly mispriced then this can easily put this metal into servicing more malinvestments.

    These kinds of economic games with models, government intervention, inflation, stimulus has to stop, if not for the simple reason that the Earth simply does not contain an unlimited amount of resources for us to constantly be to inflate our way out of trouble, thus leading to a great waste of resources in malinvestments.

    I have yet to really see an academic question the data itself that they’re plugging in, or that any of their models are even applicable: all models assume epistemological certainty in its data, but more so, it assumes that the economy is cyclical; however, this period may not be cyclical at all but a collapse.

    Of course academics can afford to be overly dogmatic with their models and such because for the most part they have no skin in the game. For example, we have many academic like Mr. Krugman crying that the Chinese need to let the RMB appreciate. Why? Based on overly simplistic models.

    This, I think, is going to happen: the Chinese may very well devalue, not let the RMB appreciate. I suspect that the Chinese have a major problem with inflation on their hands, and their inflation may very well be in double digits. I’m aware of what their numbers say, but there’s a lot to be suspect in their CPI and GDP (if one can actually figure out how they do their calculations). Look at their energy consumption and their infrastructure use (primarily rail) and it doesn’t appear that they have the real economic activity to back a double digit GDP growth. Also, walk around their cities: very expensive and a lot of unemployment, a lot. I think if they were to appreciate as much as many are calling for the Chinese economic would implode from hyperinflation–and with the rise of inflation a picture begins to appear why the Chinese have been pushing their people to store their savings in precious metals.

    Yet, where does this leave one? Does one just give up and say trying to piece together what’s happening is pointless? Of course not, but it will take more creativity than is often seen in academics simply adhering to favored models. In the end, with all the intervention and market distortions: how do you know what institutions are even sound? And how many are there? Financial, corporate, governmental, all of them? If insolvency is present on a mass scale, albeit propped up or hidden, then the entire structure is rotten; thus, all normal or past avenues for fiscal and monetary policy to work through are corrupted–as Mr. Bernanke is finding out very quickly as all his policies have managed to do is kick the can down the road, and we’re now coming to the end.

    I suppose I’ll now get back to writing those options on the Fed Funds Rate.


    Your humble and friendly neighborhood speculator

  6. AndyfromTucson

    I think there is currently no crowding out simply because in this weak economy there just aren’t that many attractive opportunities for real investment. Real investments are motivated by the expectation of profit, which depends on expectations of growing future sales, which depends on expectations of growing future demand, which doesn’t look too promising right now. The time to go hunting for crowding out is when the economy is growing strongly and the business community is optimistic. But of course in that environment tax revenues are high and spending on social welfare programs is reduced so there is less government borrowing. So it may be possible that crowding out is a rare beast.

  7. Rich C

    One point you don’t focus on in this post, but which the graphics make clear, is that during the late 1990′s, when the budget was in surplus, the real long term interest rate for corporate borrowing was significantly higher than in the 2000′s, during which time the Federal gov’t was running sizable deficits. If you stretched your analysis back further time, and even if you looked as “riskier” rates (BBA or the prime), you would find the same thing. There is no empirical substance to the crowding out argument, not now, not in the late 1980s/early 1990s, not when deficits are large, not when the gov’t runs a surplus. It would be fascinating to read a post from a well regarded neoclassical macro economist that acknowledged this point.

  8. Cedric Regula

    I feel your pain. What you are describing is what some clever economists describe as “crowding in”. This is where you make safe, prudent saving and investing so distasteful, and treat someone trying to handle their their money that way as a common criminal for withholding cash from the economy.
    I don’t want to play.
    The other thing when discussing “crowding out” is, are we talking about reallocation of investment or borrowing towards the government, or is it re-evaluating risk on the alternatives. In this environment (there is no risk on anything, it’s all insured with CDS and interest rate swaps), it would be important to distinguish the two.

  9. flow5

    Any deficit, by definition, creates a demand for loan-funds. The larger the deficit, the higher interest rates will be, or the less they will fall.

  10. Steve Kopits

    I don’t think we have crowding out right now. Would private sector activity be higher if the government weren’t borrowing? I sincerely doubt it, not at either short or long term interest rates today. In the 1970′s, when we did arguably see crowding out, people would say, “Who can afford to borrow at these rates?” I have not heard anyone say that.
    ‘Crowding in’ is more likely; government activity has tended to support the economy.
    On the other hand, at some point the bills come due. The service on recently-incurred government debt has potential to crowd out private sector consumption on the fiscal side. That doesn’t necessarily mean that people will be unemployed, but that their taxes will be high and their consumption lower. The effect shows up in a different sector of the economy in a different way at a later time.
    On a related topic, I’d love to see an analysis of Ken Rogoff’s comments on Bloomberg today:
    I thought his analysis was very interesting, and frankly, a bit scary. I’d be curious for Mssrs Chinn and Hamilton’s take on it.

  11. MF

    Menzie Chin:
    Then how would you explain the collapse in private savings from 1995 to 2000 at a time of economic growth and budget surplus, with relatively high -compared with today- interest rates? The Loanable funds framework can not explain this. How would you explain skyrocketing private savings with skyrocketing budget deficit, relatively low interest rate and high economic growth during WWII in the US? Crowding out theory is useless in explaining this reality. Is it not time to think outside the box and look for alternative explanations?
    When a government creates a deficit, someone somewhere (let say Individual A) gets a T-Bill in exchange for his US dollars and someone somewhere (let say individual B) gets US dollars from deficit spending (eg. welfare payments). This much is certain. For individual A, exchanging US dollars for T-Bills is NOT an act of depleting his savings. (If personally you exchange your US dollars for US T-Bills, would you say that you are depleting your savings? Of course not). Now Individual B that got the US dollars (welfare payments for eg) would deposit these dollars in a US bank account. So his savings would go up. So this simple example illustrates that a budget deficit results in an increase in private savings at the aggregate level. This is precisely what the first two graphs show on your October 26, 2009 post.
    Of course, the Current Account deficit can complicate this picture since Individual B could always spend the US dollars he received on imported products (thereby transferring US dollars abroad). Nevertheless, the relationship between budget deficit and private savings is extremely robust since 1930s: budget deficit generates privates savings. This is not an awkward economic theory, this is an accounting identity (follow the money!).
    I have looked at private savings vs fiscal deficit for Canada and Australia and there is an almost perfect correlation between budget deficit and private savings as well in the last 30 years in these two countries. In fact these two countries have run budget surpluses for most of the past several years, and have totally depleted their privates savings in the process (Australians and Canadians citizen are now more personally indebted than average U.S. citizen, which is not a small accomplishment)

  12. Anonymous

    I don’t think we’d see the rates we do if the government wasn’t borrowing. People would rather make 3.5% or 4% than not make anything at all. The smart thing to do would be for lenders to work real hard at refinancing current borrowers who can make good on their debt. This would free up a whole lot of income for investment, savings, and spending.
    Right now, the banks are borrowing cheap, and likely ultimately lending back to the government while they continue to collect the high rates on inflated prices (nominally low rates, but high considering that the interest is on a greatly inflated property value, and the low rates we’ve seen are likely inflated by government borrowing).
    Of course, Steve’s right, stopping government borrowing won’t get banks to start competing with each other to get existing good debt on their books at low rates. They’d rather squeeze an much out of their existing debts as possible even if it breaks a lot more people than a rate that reflect the realities of low future economic growth.

  13. Raphael

    If I understand this and the Powerpoint correctly, then we can expect two things:
    - either government bonds are closer substitute to money which would entail high future inflation,
    - or bonds are closer to capital which would entail low future private investment.
    If bonds are in the middle of the road between money and capital, we should expect a bit of inflation and a bit of low investment… Am I getting this right?

  14. Brian


    I’ve never heard of a risk free investment.

    I personally wouldn’t invest on the thesis that there’s no risk out there: CDS’s and Swaps have counterparty risk; and with the changes in derivative insurance, the insurer doesn’t need to have the capital to cover its underwriting (this was what ultimately helped blow AIG up).

    Of course if you’re on an exchange, then the exchange is the counterparty; but still, such strategies only mitigate risk, not offset, because to offset your risk, your hedge would have to move equally inverted, thus the best you could do would be break even (you might even lose money due to slippage).

    Of course there are safer investments one can make where the loss may not be foreseeable, but the amount is; that is, underwrite the risk that interest rates won’t go lower in order to cheapen an option that the Fed won’t raise interest rates over the next few months.

    However, with the unimaginable debt in the system, even growing, at some point this will ultimate implode: the only question now is what avenue of implosion do we wish to take. But let’s say that they somehow manage yet again to avoid an outright collapse, after all, they were able to do it many time in the last 20-30 years (of course we’re reaching the end of the rope here). What ever recover people might be under the impression that is going to happen simply won’t because out there, lurking and waiting, is a ceiling more powerful than an Central Bank, government, or economic theory, and that is energy limitations. Take a look at the graphs of the top 300 oil fields in the world, and they’re all either in decline or plateaued.

    And as everyone rushes to devalue, someone is going to screw up and send massive crashes through the currency markets (Eastern Europe being a prime suspect to get things rolling)–and if you thought there’s volatility now in the currency market, just give it time. However, in the end, everyone has adopted the same strategy: devalue in order to increase exports to bolster the economy. This is an unworkable scenario when everyone is doing it and no one wants to play the strong currency role. And forget about looking to the Chinese, that’s a dead end: consumption as a percentage of GDP has been declining and they’re at this moment increasing manufacturing capacity, not with the intent of absorbing everyone’s exports.

    And forget about the US consumer, they’re tapped out: and the data on the consumer isn’t so much distorted as it’s misunderstood because interest payments and transfer payments cause distorted readings if these things are not considered (because it’s unsustainable to have tax revenue collapsing, yet transfer payments increasing). Also, unemployment is nowhere near what the BLS is stating. A lot has to do with modeling distortions (as the BLS has addressed by saying it doesn’t have a solution, as they imply this is not a typical business cycle downturn), and they really have no way of counting subcontractors, which a lot of employment was over the last ten years was due to the housing market (as agents, brokers, construction workers, etc tend to be).

    A quick look at a stat should give one some dire impressions: light vehicle sales. They’re at about 1982 levels on an annual rate, however, the population is much greater, therefore, sales are much worse then the sales graph might suggest.

    The American consumer is in horrific shape, and this is much of the foundation of the American economy. And the anecdotal evidence of what’s happening in the real economy is much worse.

    The point is, in such an economic environment (where we also have a building resource scarcity, budding political instability), investments with counter party risks are very risky, indeed. This is why we see the gold market taking off for the last nine years: there’s no counterparty risk. Gold is not an inflation hedge, it never has been used that way: it’s a geopolitical hedge; and in a geopolitical crisis: it’s best to avoid as much as possible counterparty obligations–and as we’re going to see, the unions and the public workers are going to discover that there’s no such thing as a guarantee, that is, a risk free investment.

    Remember: US Treasuries are not considered risk free, this is often misquoted: they’re considered to have no perceivable risk. Perceivable to who? I guess time will tell. Bonds should continue to rally for awhile as hot money needs to find a home, and this money, which is really inflation, as it wasn’t derived from production, will send the false signal that the government can continue to borrow, which it will, and you’ll have the likes of Mr. Krugman cheering it on, only for the rug to eventually be pulled out, and interest rates suddenly shoot to the moon.

  15. Cedric Regula

    “I’ve never heard of a risk free investment.”
    I was being facetious. I wish HTML had a different font for it.
    “I personally wouldn’t invest on the thesis that there’s no risk out there: CDS’s and Swaps have counterparty risk; and with the changes in derivative insurance, the insurer doesn’t need to have the capital to cover its underwriting (this was what ultimately helped blow AIG up).”
    Exactly my feeling. The global financial system has mispriced risk, and if interest rates are too low, also mispriced stocks and commodities, because one factor in their valuation is returns vs cash return.
    So the financial system is like a great big AIG selling phony insurance, the effect being making these assets sell at near risk free prices.
    Very much agree that Treasuries are not risk free, especially if we toss in interest rate risk, or inflation risk on 10s and 30s, if not shorter duration issues.
    Warren Buffet calls it financial WMD. The powers to be know we need to change the system, but no meaningful changes have been made yet, except ramping down leverage somewhat with the conversion of IBs to commercial banks.

  16. aaron

    For interest rates to even be where they are at, real estate prices need to come down some. For interest rates to be higher, prices have to come down more.

  17. Brian


    Lol, I suspected that you were being facetious (lol, and hoping); but in these times, well, I’ve heard many crazy things; and, unfortunately, many people are acting as if there are risk free investments–sadly, many of these investments, whether involuntarily or voluntarily, involve money they cannot afford to lose, whether if be their children college money, retirement, etc.

    A fundamental problem I see, from data or personal observation, is that a sort of nihilism has swept over the broader culture. I see this in these fund managers who play with money that the working class investors really cannot afford to lose (especially 401k, pension, and insurance). The managers, for the most part, simply don’t care, it’s all about getting that quick performance bonus; and so now the number one goal of these managers is to make money–however, the number one goal of an investment manager should be to not lose money, and then the second goal is to make money.

    What is taking place is more of a fundamental cultural-instinctual level; and I must admit, that the success I’ve had investing I would attribute more to reading and contemplating Nietzsche, Shakespeare, or Montaigne than any economist or economic theory.

    If the Western World, and perhaps the World as a whole (since it has been on an insane quest to mimic the decadent parts of the West), has hit its height, then of course it’s axiomatic that a decline is taking place–one can’t establish the highest peak until there’s a downward turn.

    Unfortunately, we have compartmentalized, and then departmentalized, of thinking, research, analysis, and even our communication to the point that one’s small specialty is mistaken to be sufficient to understand the world at large.

    Economics is simply one part amongst many parts of the whole.

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